In March 2021, a digital ownership token, or NFT (Non-Fungible Token), for a digital art called Everydays: the first 5000 days was sold for US$ 69 million. While the art itself is could still be seen, copied, or even printed by anyone, its ownership is kept by the token holder. Furthermore, the buyer recently goes even further by allowing anyone to download a copy of the token¹. This encapsulates the uniqueness of NFTs, where it is both valued very highly, but also are not something exclusive to the owner.

NFTs, in its current form, are a part of the decentralized crypto ecosystem. This ecosystem is made using many types of technologies and applications, including blockchain and smart contracts. These technologies are applied in their own financial services sector, decentralized finance (DeFi), and have many potential applications in improving the existing finance, including Islamic Finance.

This article focuses on NFTs and Smart Contracts. NFTs has became a rising sector in the digital economy, growing from US$400 million in monthly sales the start of the year, to around US$ 2 billion, according to JP Morgan². This rise, coupled with the aforementioned uniqueness of NFTs makes it an interesting and increasingly important sector. On the other hand, smart contracts seem to have clear utilities through its self-executing and immutable nature, to potentially improve finance in general, and islamic finance specifically. Moreover, especially compared to blockchain, smart contract have received relatively little attention, making its benefits less known.

NFT stands for Non-fungible token. NFT is defined by EY as a unique digital asset recorded in a blockchain³. As it is unique and not interchangeable, NFTs can be used to represent ownership of a unique digital or physical asset. NFTs combines both the decentralized trait of blockchain and the uniqueness of a nonfungible asset⁴. NFTs makes a digital asset, which is previously easily replicated, able to have scarcity and original ownership.

NFTs can commercialize unique assets which are previously difficult to sell or prove ownership, such as a video, photograph, or even a tweet. Anyone can copy a digital file, including something represented by an NFT, however, they cannot claim the ownership itself⁵.

As NFTs are built on smart contracts, they can also be programmed to add different functionalities, such as sending royalty to the creator each time the NFT is transacted⁴. Currently, NFTs are transacted on specific marketplaces such as OpenSea, which is the largest NFT marketplace with over US$10 Billion in total sales⁶.

1.1.1. Current Application And Risks Of NFTs

The first sector where NFTs became mainstream is the digital art market, where artists are able to fight plagiarism and monetize their arts by using NFTs to sell the ownership of their arts and earn royalties³. Currently, the crypto art sector have an overall market cap of over US$1,2 billion⁷, and the most expensive NFT as of writing is the aforementioned a digital art called Everydays: the First 5000 days, and many other NFTs have already been sold for millions of dollars.

Another sector which prominently uses NFTs is gaming, such as for selling digital gaming assets. This allows people who previously does not actually own these assets to sell them in an outside marketplace⁸. Collectible limited items also has a large NFT market. One of the successful milestone collectible crypto projects is CryptoPunks, 10.000 unique pixelated characters where the most expensive one is sold for US$ 11,8 million^{3, 9}. Even large sport leagues such as the NBA has also entered the NFT market through NBA Top Shot, selling NFTs of in-game highlights5.

NFTs are also getting more influential in Decentralized finance (DeFi), decentralized applications based on blockchains which provides financial services. Currently, NFTs mainly function as collateral in DeFi. The DeFi marketplace NFTfi offers P2P loans backed by NFTs as collateral⁴, and they have disbursed over US$32.000 in loans since its launch in June 2021¹⁰. Other sectors of NFTs includes ticketing and virtual assets, such as domain names and virtual land, which are offered in virtual world platforms such as Decentraland.

However, there are certainly risks involve in utilizing new and innovative technologies like NFT. As NFTs are new, there are little regulatory frameworks applicable to NFTs. Furthermore, as blockchains apply accross national borders, it is even more complex to regulate NFTs⁵, and this uncertainty creates risk for any NFT transaction. Environmental impact is also a concern, as NFTs mainly use the Ethereum Blockchain, which consumes a large amount of energy and has a large environmental impact. This concern may be reduced in the future as ethereum switches its validation method and better technologies are applied. Other risks includes data security, litigation, and reputational risk⁵.

1.1.2. Theoretical Application Of NFTs

Even though digital art is the dominant art form to be minted into NFTs, any form of art potentially can be minted into an NFT. For example, other sectors such as movies may in the future change their works into NFTs so that they can get royalties each time their work is displayed³.

Currently, NFTs are mostly used for digital assets, but it potentially may be used for real, tangible assets in the future. For example, Real estate-based NFTs can accelerate ownership transfer using smart contracts and blockchain. Goods can be tracked during the supply chain process using NFTs, empowering the manufacturer to identify fraud³. However, according to the CEO of Outlier Ventures, this application is still ways away as real world assets are still ”a decade long fight” from being minted into NFTs¹¹.

NFTs are also theoretically able to be used for personal identification, making people’s personal information more secured and controlled⁴. In DeFi, the revenues from NFTs, such as royalties, can be integrated to financial institutions in order to improve someone’s credit rating. NFTs can also be used to identify licenses and certification3.

However, there are real obstacles to mass adoption of NFTs that needs to be solved for these applications to be realized⁴. Currently, NFT technology is still very young, which create questions regarding its safety and authenticity. Guaranteeing NFT claim on a real asset can be difficult, and may need real world companies to issue their own NFTs or partner with crypto companies. Other obstacles includes the aforementioned lack of regulation, the high and volatile transaction fees of blockchain networks, and the current relative inaccessibility of NFTs as the barrier to participate is still relatively high.

According to the World Bank, Smart contract are automated contracts in the form of codes that self-executes with certain conditions and is immutable once deployed¹². Therefore, smart contracts have 2 main properties, which are self-executing and immutable, meaning that they execute automatically without human interference, and cannot be changed or modified.

Smart contracts are mainly used in conjunction with blockchain, so much that many described smart contracts as codes written on blockchain. With blockchain, smart contract can create a more transparent, automated, and efficient way in facilitating many contractual processes¹². This is particularly useful for monitoring agreement performance, reducing the need for third parties.

Currently, smart contracts are mostly applied in the cryptocurrency ecosystem. DeFi uses smart contract to create automated exchanges and lending, creating an permissionless system and automating every function¹³. Other decentralized applications, such as DAO (Decentralized autonomous organization), also function using smart contracts to automate and decentralize their functions.

The applications of smart contracts are useful for operations that has a straightforward logic, but difficult for operations that needs judgement¹². For the right kinds of operations, smart contracts would alleviate process friction, reduce costs such as operational, fraud, and legal risk, and improve trust. Proponents of smart contracts states that it would create efficiency and reduce legal discrepancy.

However, smart contracts does not alleviate credit risk or improve borrower creditworthiness. Several other impediments of financial inclusion also cannot be alleviated by smart contracts, such as distance, accessibility, awareness, literacy, and culture. Critics of cryptocurrency states that modifying, amending, or terminating smart contracts can be difficult because of its immutable nature¹². There are also inherent risks such as coding errors, and the inherent transparency of smart contracts can made it vulnerable to exploits¹⁴.

The biggest opportunity for the use of smart contract is on the supply chain and insurance sector¹². Process friction and information assymetry in supply chains can be reduced with smart contracts, which would improve speed, efficiency, and lower costs. For insurance, smart contracts can improve claim and dispute resolution, alleviate friction, and improve trust. But as mentioned, this can only be used for straightforward tasks, such as disaster insurance which is linked with weather index, while more judgement-based insurances are more difficult. Though less clear cut, consumer credit can be improved through automating certain processes such as loan servicing.

As NFTs are still a developing field, the fiqh regarding it would evolve as different NFTs are created. According to Faraz Adam, NFTs are permissible as long as the asset which the NFT represents is sharia compliant, and there are no potential issues which risks sharia non-compliance¹⁵. For example, NFTs for arts which display limbs that should be covered, or for tickets to unlawful events are not sharia compliant.

An important point regarding NFTs in sharia is that it should have an actual benefit, and not considered extravagant or wasteful. Trading only in assets that have an actual benefit and utility is one of the primary principles of sharia¹⁶. While extravagance, or israf, which means excessive consumption is disapproved in the Quran and is disliked by Allah (Quran 7:31). Wastefulness, or squandering and dissipating recources is also condemned in the Quran, which compares it to satanic behavior (Quran 17:26-27)¹⁷.

Therefore, tokens which do not have actual utility and real use is not aligned with sharia principles¹⁵. This includes NFTs for collectibles which are mere amusement, or for games which lacks reasonable purpose. Even though something has financial value, if its utility and value does not align with sharia principles, this might be included in the prohibition of squandering wealth for useless items. NFTs which are overly luxurious are also not sharia-aligned as they fall under the prohibition of extravagance, although what constitutes as luxury is not precisely defined in sharia and might vary between people¹⁷.

It should be noted that there had been few rulings on the overall cryptocurrency ecosystem outside of cryptocurrency itself, as this is a new and evolving subject. According to Faraz Adam, smart contracts themselves are value-free and neutral¹⁸. Therefore, as there are no reason to forbid, smart contracts fall under the islamic legal maxim of permissibility by default.

However, the contents of the contract determines whether that particular smart contract is sharia compliant or not. For example, DeFi lending contracts with interest, or DeFi speculative derivatives is not sharia compliant. As the sector continues to evolve, new fatwas and guidelines would be needed to ensure the sharia compliance of each product that uses smart contracts.

The clearest potential use of NFTs in Islamic Finance is as collateral, its current application in DeFi. NFTs used as collateral for Islamic Finance would have similar benefits as it would give for other finance sectors, such as decentralization, traceability, and preventing frauds or plagiarism. This would also give sharia-compliant financing access for more people, such as digital sharia-compliant artists and NFT owners.

NFTs is especially applicable in Islamic Finance if NFTs are able to be minted for real world assets, as one of Islamic finance main themes is its connection with the real economy¹⁹. For example, instead of giving away physical documentation in car financing, the borrower can simply give the NFT of the car. However, If only digital items are able to be minted into NFTs, it would make the connection to the real sector much more limited.

Applying NFTs in Islamic Finance can start with developing the Islamic DeFi market, which is currently nonexistent. Furthermore, there should be guidelines and clear fatwas on the sharia compliance on NFTs, and if the concept of NFTs are halal, how to to identify whether an individual NFT is sharia compliant. Halal NFT marketplaces should also be developed as at the time of writing, there has been no halal NFT marketplaces or sharia-compliant filters yet.

Applying smart contracts to Islamic Finance would have a similar benefits as it would give to conventional finance, including efficiency, security, and trust. As fulfilling contracts is a direct order from Allah in the Quran (Quran 5:1), any sharia-compliant innovation that supports it should go in hand with islamic values. And through its self-executing feature, smart contract would be able to support the fulfillment of contracts while being a neutral sharia-compliant tool.

One of the existing smart contract application in Islamic Finance is the Smart Sukuk of Blossom Finance. This is one of the few innovations which link the cryptocurrency ecosystem with the real sector. Blossom Finance uses a smart contract-based sukuk which is used for investing in MSMEs in Indonesia, improving investment and financial inclusion²⁰. Using smart contracts in sukuk would eliminate the need for intermediary in issuance and ensure standardization.

Blockchain and smart contracts can also be potentially used to improve the performance of islamic social finance such as zakat. Rejeb (2020)²¹ created a funding model which combines zakat management with blockchain and smart contracts. This would theoretically identify potential zakat payers, therefore improving overall zakat collection. This model would also create a more trusting environment from transparency and automation, and also reduce time costs, among other benefits.

In conclusion, from the Islamic perspective, NFTs and smart contracts are generally permissible, as long as the asset or contract within is sharia compliant. In NFTs especially, an important aspect is that the item must have an actual benefit, as Islam prohibits squandering wealth for useless items. In terms of applications, NFTs can be useful in Islamic Finance especially if it can be used to represent real asset. While smart contracts, as a singular concept, seems to be very much aligned with Islamic values as it can support the fulfillment of contracts, among other benefits.

Going forward, as mentioned, there should be a clear guideline on the sharia compliance of NFTs itself and also the object it represents. Several Islamic Based NFT marketplaces, such as Funoon, is developing a faith-based NFT marketplace which allows its creators to set aside a certain percentage of the price for charity. In terms of smart contract, new innovation and application using smart contracts should be continually developed. Marhaba DeFi is currently developing a sharia-compliant DeFi platform, with smart contracts playing a crucial role.